*I am not a tax professional. This is meant to be an educational tool and NOT a recommendation. Each personal situation is different and there’s a lot of grey area in self-employed deductions. If you have questions (even just little ones) … talk to a tax expert.*
A little while back I wrote an epic RRSP break down complete with colourful pictures and my new adorable mouse friend, but it’s worth taking a specific look at just the ‘tax deduction’ portion of the RRSP universe.
It’s got to be one of the easiest ways to lower the amount of tax you have to pay in a given year… but it still might not be the best choice for everyone.
How does it work?
This one is pretty simple. #famouslastwords
When you put money in an RRSP you don’t have to pay tax on that money until you take it out (hopefully years from now).
Now, it’s important to remember that although this deduction is very real, it’s also temporary. All the other deductions we’re talking about are forever, but you will have to pay tax on your RRSP contributions at some point…
So it takes a little strategic thinking.
How to use the RRSP deduction like a super smarty
Let’s take a little review on what a deduction is: when you deduct income, you don’t have to pay tax on that income… so it lowers the TOTAL amount of income that you’re paying tax on.
Now since in Canada we use a marginal tax system … tax deductions can save you a ton of money by lowering your total income and getting you out of some of those pesky upper taxation margins.
Here’s a reminder of how that works….
But remember… since you have to pay tax on your RRSP contributions eventually… it’s worth it to take a look at your tax situation and decide if it makes sense to pay tax NOW or LATER.
The situation that gets best value from an RRSP deduction is when current high earners expect to make less when they eventually use their RRSP funds.
What makes that the best value?
OK, let’s say you make 100,000 dollars a year:
Now… if you put 10,000 dollars into your RRSP, what happens?
Well, right away you’ve decreased your ‘taxable income’ to 90,000.. which is nice, not only because you have less income that will be taxed, but because that top 10,000 dollars was mostly being taxed at 43%. That means you would have been paying about 4,300 dollars JUST on that money you socked away in your RRSP.
That’s a great savings… but it’s not completely real. Remember, at some point you will have to face the tax dragon.
The thing is… when you get to your later years, and you’re thinking about taking money out of your RRSP… maybe you’re not making 100,000 dollars a year. Heck, maybe you don’t need nearly that much. Your life might be a little simpler. Your house is paid off. The kids have moved out. Your business doesn’t need all that investment anymore.
Maybe you just need 40,000 to come out of your RRSP to pay your expenses that year.
So when you eventually take out that 10,000 dollars it’s no longer the top 10,000 of a 100,000 dollar income. It’s the top 10,000 of a 40,000 dollar income.
That money is now taxed in a way lower bracket.
You managed to save yourself more than $1,600 in taxes, just by stowing away money when you were in a high bracket, and paying taxes later… when you were in a lower bracket!
Now that’s a spicy tax deduction!!